How a Debt Downgrade May Affect Consumers

Tuesday

If the nation’s credit rating is downgraded because of the debt standoff , investors and borrowers should be able to ride out any resulting volatility, experts said.

This is not yet one of those stuff-your-money-in-a-mattress moments.

Still, the talk in Washington of a federal budget crisis and possible default has given rise to all sorts of consumer fears of doomsday scenarios. Missed Social Security payments. Spikes in interest rates. Draconian cuts in government services.

But the most likely outcome, experts said in interviews this week, is that the nation’s credit rating will be downgraded a notch. And if that turns out to be the case, investors and borrowers should be able to ride out any volatility.

Over the last few days, financial advisers have tried to allay investor fears by sending notes to clients with the same message they have delivered in past periods of market uncertainty: As long as you’re diversified across different investments, the best action, in this case, is inaction.

The financial markets may become more volatile in the near-term, they say. And interest rates on several types of consumer loans can be expected to tick modestly higher because the rates track government-issued debt. But a credit downgrade is unlikely to cause a major shock to the system.

That said, the only investment that did not plunge in the 2008 market crisis was Treasuries, and they could conceivably lose some of their luster. “Sometimes I worry that a U.S. debt downgrade could have long-term negative psychological consequences as Americans realize the greatest power on earth is, alas, a mere mortal too,” said Milo Benningfield, a certified financial planner in San Francisco. But “we’re still looking pretty good relative to most everyone else in the world.”

That does not mean there will not be a wide ripple effect, at least in the short term. The magnitude of the deficit reductions and their effect on the broader economy are another wild card. But in the near term, here’s what investors and consumers can expect, and some advice from experts.

STOCKS AND BOND INVESTMENTS Both the stock and bond markets are expected to endure a period of volatility if the nation’s debt drops a notch from its AAA perch. “Once a plan is in place, we would expect the markets to return to normal, and for investors to focus on more fundamental issues like long-term earnings growth and the economic health of countries around the globe,” said Gus Sauter, chief investment officer at Vanguard.

“That said, it’s simply not possible to gauge precisely how the equity and fixed income markets would react and for how long, so the best course of action is to ignore the headlines and maintain a long-term approach.”

That sort of advice might come as cold comfort to people on the cusp of retirement, and for whom the memories of the recent downturn are fresh. That is why many advisers suggest that people who are living off their investments set aside enough cash so that they are not forced to sell investments during a rough patch.

“This is certainly creating a lot of concern, and the games being played in Washington by Congress are increasing the stress,” said Diahann Lassus, a financial planner in New Providence, N.J. “Cash reserves are very important for both retirees and pre-retirees.” She suggests six months to two years in cash, depending on the investor’s age and specific situation.

A downgrade may cause Treasury yields to move modestly higher, which, in turn, may cause corporate, municipal and other bond issues to follow suit. Budget cuts, though, may have a more serious effect, depending on their severity. “If they really make some severe cuts, that is deleterious to the municipal bond space,” said Marilyn Cohen, chief executive of Envision Capital Management, which manages bond portfolios. “That means less trickle-down to the states, cities and counties.”

But if there are not enough cuts, she said, that could also cause the broader bond market to swoon.

MONEY MARKET FUNDS These funds hold 40 to 45 percent of the shorter-term Treasury debt outstanding, according to Deborah A. Cunningham, chief investment officer for money markets at Federated Investors. But if the nation’s debt rating were downgraded, these funds would not be required to sell the Treasuries they hold. In fact, a fund would not be required to sell in the event of a default, either, as long as the fund deems the securities to be safe and able to make their interest payments.

“The money market world asset flow, what comes in and goes out, has been pretty benign,” Ms. Cunningham said.

And she said she would not expect a downgrade to change those flows in any significant way. “The debt that is held in money market funds is so short in maturity that a downgrade will just not be an event that causes any kind of pricing concerns. As such, there shouldn’t be issues for investors.”

HOME LOANS AND CREDIT CARDS Fixed-rate mortgages generally track the 10-year Treasury note, whose interest rates would rise in the event of a downgrade. “The concern behind rates rising comes from the risk that investors — foreign and domestic — would rush to sell U.S. debt,” said Cameron Findlay, chief economist at LendingTree.com, noting that a sell-off would push the price of the debt lower, while causing its yield to rise. “So the question then is by what magnitude, and that remains the unanswered element everyone is struggling with.”

Shortly after a downgrade, he said, he would expect interest rates to spike a bit, though he said he did not expect rates on fixed-rate mortgages to rise more than half a percentage point to a full percentage point, at most. Nor did he expect a rise in rates to affect the pace of lending. After all, stricter credit standards are making lending difficult.

But once the federal debt issue is resolved, he said he expected mortgage rates to fall back to the range they are in now. Rates on a 30-year fixed mortgage averaged 4.52 percent for the week ending July 21, according to Freddie Mac. Though adjustable-rate mortgages typically do not track the 10-year Treasury note, experts said those rates could still move modestly higher.

Home equity lines of credit, meanwhile, track the prime rate, which is generally pegged to the federal funds rate. “Do we expect that to increase any time soon?” he asked. “We don’t. But if the risk of inflation increases, then, of course, the risk is that you will see that index start to increase.”

Credit cards are also pegged to the prime rate, so any increase in interest rates is more likely to be a result of broader economic factors or a decision by lenders to increase their profit margins. But as Greg McBride, a senior financial analyst at Bankrate.com, said, lenders must give borrowers at least 45 days’ notice before raising their interest rate, and that can be applied only to new balances.

STUDENT LOANS The interest rates on most private student loans are pegged to the London Interbank Offered Rate, or Libor, which is influenced by Treasury yields. So if the yields on government securities rise, student loan rates could rise as well, said Mark Kantrowitz, publisher of the FinAid and Fastweb Web sites. Borrowers taking out new loans, however, might see a greater increase in costs because of activity in the securities market backed by student loans.

Federal student loans are made by the government, which sells Treasuries to raise money to finance them. The government profits on the interest from the loans. If the government’s cost of borrowing rose, the government’s profit would decrease. But for now, since the interest rates are fixed, students would not necessarily see their costs rise unless Congress passed legislation to raise rates, he said. And then, the higher rates could apply only to new loans, he added.

The deficit reduction plan, which is likely to cut education spending, could have a broader effect on student lending. Some proposals, for instance, would cut subsidized interest on loans to graduate and professional students.